To buy equipment and run your business, it's inevitable that you'll incur debt at some time or another. Generally, interest on business loans is fully deductible against business income. For example, if the business takes a loan to buy a machine, the interest is deductible without limitation. But there are some limits on business-related interest deductions to consider:

  • Loans to purchase a business. The treatment of interest depends on the nature of the business you acquire. Interest on a loan to buy stock in a C corporation is considered investment interest - - deductible to the extent of net investment income (with excess interest carried forward to future years). Interest on a loan to acquire a share in a pass-through entity - partnership, limited liability company or S corporation is treated as a "debt-financed acquisition." This means that the deductibility of interest depends on the underlying assets of the entity. For example, if you acquire an interest in a pass-through entity that owns equipment worth $90,000 and stocks in other companies worth $10,000, then 9/10ths of your interest payments are fully deductible business interest; one-tenth is investment interest. The allocation of interest for a debt-financed acquisition can be based on book value, market value, or the adjusted bases of the assets.
  • Retirement plan loans. If you borrow from your qualified retirement plan and use the funds for your business, the interest you pay back to the plan is nondeductible. Key employees (which include owners) cannot deduct interest on plan loans. Note: Sole proprietors, partners, members, and certain S corporation shareholders that were previously barred from taking plan loans can now do so if their plans are amended to permit plan loans (this borrowing is no longer considered a prohibited transaction subject to penalty). They can use their retirement accounts as a ready source of cash for their business needs.
  • Tax payments. If you charge income taxes on your credit card, interest related to taxes on your interest in a sole proprietorship, partnership, limited liability company, or S corporation is not deductible. This includes not only the interest charge but also the 2.5% processing fee for charging the taxes. Interest paid to the U.S. Treasury on tax underpayments related to these pass-through entities is also nondeductible. Note: C corporations can deduct interest on any tax underpayments.
  • Construction loans. Interest incurred to construct business property -- an office building or factory for example - - must be capitalized as a construction cost. The interest is then amortized and deducted over the life of the property.
  • Entire contents copyright © 1998 - 2003 Inc. All rights reserved.